Trading plans that focus on knowns are better than those based on unknowns. Said another way, trading plans built on predictable variables are better than those created around unpredictable ones.

Take the covered call, for instance. It’s a system I touch on almost every single day in my teaching ventures. For the uninitiated, a brief review is in order.

The covered call is a cash flow trade involving buying 100 shares of stock and selling one call option. In exchange for obligating yourself to sell your shares, you get paid a premium. The premium provides potential cash flow and some downside protection to offset losses in the stock. Placing the trade is easy. But managing it can get a bit tricky if you overthink things. Indeed, many rookie traders struggle with all the different ways to handle the short call portion of the trade.

For example, you can base your management over whether you think the stock will rise or fall. Here’s how the reasoning goes. The stock is breaking out and looks to head higher. I better repurchase my short call now because if I wait, it will cost more. But will it? Maybe. It’s an unknown.

Or maybe you reason the call will remain sideways or drop a bit. Better stay in the short call then because you’ll be able to buy it back cheaper later. But will you? What if your stock forecast is wrong and the underlying rips higher? You simply don’t know.

So rather than basing your management on your stock bias, how about basing it on a known and perfectly predictable variable?

Extrinsic Value

I’m talking about the extrinsic value (EV), otherwise known as time value. Its behavior is much easier to forecast than price direction. And that’s why most traders use it as the guide for managing short calls.

The rule can be simple such as buyback your short call when there is little time value remaining such as 5 cents or 10 cents. Some systems, like Tackle 25, focus on exiting when you’ve captured a large percentage of the premium such as 75% or 80%. For instance, if I sold a call with $1.00 of EV, I would look to repurchase it when the EV dwindles to 25 or 20 cents.

The primary two variables that impact EV are time and price movement. Time is the simplest. As it passes, options lose EV. We call it time decay. It causes time value to drop daily bit by bit, bringing you ever closer to your target.

Stock price movement can cause EV to drop rapidly. Much quicker than time passing. That’s because options lose EV as they move ITM or OTM. So if your stock skyrockets sending the short call deep ITM, you could capture the majority of the time value immediately. Alternatively, if the stock plunges pushing the call far OTM, the time value will disappear fast.

The Option Chain

Perhaps the easiest way to track EV is by displaying it on an options chain, like so:

Here’s the bottom line: if you want to make your covered call trading simple then craft your management around the EV.

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